Question

Capital budgeting is vital in public finance decisions. Decisions on capital project investment, discuss three criteria that are used to evaluate capital budgeting projects

Answer 1

Answer

Meaning of capital budjeting

Capital budgeting is the process a business undertakes to evaluate potential major projects or investments. Construction of a new plant or a big investment in an outside venture are examples of projects that would require capital budgeting before they are approved or rejected.

As part of capital budgeting, a company might assess a prospective project's lifetime cash inflows and outflows to determine whether the potential returns that would be generated meet a sufficient target benchmark. The process is also known as investment appraisal.

Decisions on capital project investment, three criteria that are used to evaluate capital budgeting projects are-

Below Three Approches used to evaluate capital budjecting projects:-

• Payback Period
• Internal rate of Return (IRR)
• Net Present Value (NPV)

Capital budgeting is the process by which investors determine the value of a potential investment project. The three most common approaches to project selection are payback period (PB), internal rate of return (IRR) and net present value (NPV).

Payback Period

In capital budgeting, the payback period refers to the period of time required for the return on an investment to “repay” the sum of the original investment. Capital Investment in Plant and Property: The payback method is a simple way to evaluate the number of years or months it takes to return the initial investment.

The payback period is expressed in years and fractions of years. For example, if a company invests $300,000 in a new production line, and the production line then produces positive cash flow of $100,000 per year, then the payback period is 3.0 years ($300,000 initial investment ÷ $100,000 annual payback)

Internal rate of Return (IRR)

The internal rate of return (IRR) is a metric used in capital budgeting to estimate the profitability of potential investments. The internal rate of return is a discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero.

The Purpose of the Internal Rate of Return

The IRR is the discount rate at which the net present value (NPV) of future cash flows from an investment is equal to zero. Functionally, the IRR is used by investors and businesses to find out if an investment is a good use of their money

he best way to approximate IRR is by memorizing simple IRRs.

1. Double your money in 1 year, IRR = 100%
2. Double your money in 2 years, IRR = 41%; about 40%
3. Double your money in 3 years, IRR = 26%; about 25%
4. Double your money in 4 years, IRR = 19%; about 20%
5. Double your money in 5 years, IRR = 15%; about 15%

Net Present Value (NPV)

Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period of time. NPV is used in capital budgeting and investment planning to analyze the profitability of a projected investment or project.

NPV calculates as below

It is calculated by taking the difference between the present value of cash inflows and present value of cash outflows over a period of time. As the name suggests, net present value is nothing but net off of the present value of cash inflows and outflows by discounting the flows at a specified rate

Conclusion:

Best method among the three above is NPV Method for capital budgeting Decisions

Reason:

Net Present Value Method

Net Present Value Method is the best capital budgeting method. Reasons: NPV gives importance to the time value of money. It determines how much cash will flow in as a result of the investment, and compares that against the cash that will flow out in order to make the investment.